University of Virginia School of Law Law and Legal Theory Working Paper Series 2012-04 The Effect of Bargaining Power on Contract Design Albert Choi University of Virginia School of Law George G. Triantis Stanford Law School March 2012 This paper may be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=2010083 A complete index of University of Virginia School of Law research papers is available at Law and Economics: http://www.ssrn.com/link/U-Virginia-LEC.html Public Law and Legal Theory: http://www.ssrn.com/link/U-Virginia-PUB.html Electronic copy available at: http://ssrn.com/abstract=2010083 The Effect of Bargaining Power on Contract Design Albert Choi and George Triantis* March 11, 2012 Abstract Over the past 40 years, an irrelevance proposition has been prevalent in law-and-economics scholarship: bargaining power should affect only price and not non-price terms of a contract. In contrast, practitioners and commentators in industry regularly invoke bargaining power to explain static and dynamic variance in non-price contract terms. This paper unpacks and analyzes the assumptions of the strong- and weak-versions of this bargaining power irrelevance proposition, to bridge the gap between theory and the real world. In the first half of the paper, we identify and discuss a variety of explanations for the effect of bargaining power on contract design, under conditions of information asymmetry and positive transaction costs. These include the effects of shifts in market supply and demand and the effect of bargaining through lawyers. In the second half of the paper, we present an in-depth examination of one set of explanations, concerning the impact of bargaining power and information asymmetry on non-price terms, when the value and cost of non-price terms vary across contracting parties. In the extreme cases in which one or the other party enjoys overwhelming bargaining power, the efforts of that party to capture a larger share of the surplus by screening or signaling may compromise the efficiency of the non-price terms. We show that this incentive disappears or is mitigated when bargaining power is more evenly shared between the parties: for example, when a monopolist faces the threat of competition, when the parties can renegotiate, or when they engage in bilateral bargaining with more even bargaining power. As a whole, the paper provides a theoretical basis for interpreting the intuition among market participants that the impact of bargaining power extends beyond price terms. Before concluding, we briefly suggest implications for legal policy, particularly the contract law doctrine of unconscionability. *Professor of Law, University of Virginia, and Professor of Law, Stanford University, respectively. The authors thank Isaac Belfer (Harvard Law 2011) and Neal Sangal (Stanford Law 2014) for their valuable research assistance. They are also grateful for helpful comments from […] and participants at law school workshops at Columbia, Harvard, Texas, and Virginia, and at the Theoretical Law and Economics Conference at Washington University Law School in St. Louis. Triantis thanks the John M. Olin Center for Law, Economics, and Business at Harvard for financial support. Comments are welcome to [email protected] and [email protected]. Page 1 of 59 Electronic copy available at: http://ssrn.com/abstract=2010083 Choi and Triantis Bargaining Power and Contract Design Version: March 11, 2012 Contents Introduction I. What is Bargaining Power? II. How Bargaining Power Affects Contract Design A. The Bargaining Power Irrelevance Propositions B. Bargaining Power Can Alter the Optimal Non-price Terms C. Bargaining Power Can Lead to Inefficient Non-Price Terms D. Bargaining Power in Two-Staged (Price-First) Negotiations III. Product Quality Under Monopoly and Perfect Competition IV. The Effect of Uneven Bargaining Power Under Asymmetric Information A. The Irrelevance Proposition under Complete Information B. Private Information and One-Sided Bargaining Power 1. Dominant Seller 2. Dominant Buyer V. The Effect of More “Even” Bargaining Power A. Threat of Competition B. Renegotiation C. Bilateral Negotiation VI. Bargaining Power, Discrimination and Legal Policy Conclusion Page 2 of 59 Electronic copy available at: http://ssrn.com/abstract=2010083 Choi and Triantis Bargaining Power and Contract Design Version: March 11, 2012 Introduction When two parties enter into a contract, their relative bargaining power affects the terms of their deal. While the allocation of bargaining power clearly determines price, it is an open question whether and how it also affects non-price terms (what we are alternatively referring to as “contract design”). It is common for practitioners and industry observers to attribute seemingly one-sided non-price terms to unequal bargaining power and to explain changes in non-price terms over time as a result of shifts in such power. Consider the following examples of such observations: 1. Disclaimers of warranties and limitations on damages in a sales contract are due to the power of the monopolist. 2. Broad termination rights are included in a merger or acquisition agreement when the acquirer has the power to dictate the terms of the agreement to the target company. 3. The purchase order forms of a large corporation, facing many potential suppliers, insist that all litigation will be held in the courts of the purchaser’s state. The objective of this paper is to begin a systematic analysis of how bargaining power might determine the agreement to such apparently one-sided terms. An important normative question is whether the efforts of the stronger party to appropriate a larger share of the surplus through these terms compromise the size of the surplus. Would a more equal sharing of bargaining power be more likely to lead to efficient (surplus-maximizing) contract provisions? In legal scholarship, the issues of one-sided contract terms bear on the antitrust regulation of monopolies, as well as the policing of contracts under the doctrine of unconscionability. Early legal scholarship maintained that monopolists often used contracts of adhesion that contain one- sided terms.1 Law-and-economics scholars argued in response that bargaining power affects price, but not other terms.2 The basic argument can be found in an early work by Richard Posner, who argued that a profit-maximizing monopolist would offer product quality that efficiently meets buyer preferences, i.e., increasing quality until the incremental cost of further increase outweighs the incremental value to the buyer. Thus, a monopolist producer of cars should find it in its self-interest to offer any warranty for which the buyer is willing to pay more than the cost to the producer, just as if it were a seller in a competitive market. The difference between a monopoly and a perfectly competitive market, then, should be the market price, not the warranty terms offered. The argument that a monopolist extracts its rent through price rather than quality continues to be the conventional wisdom among the leading scholars in law-and-economics to 3 the present. 1 Friedrich Kessler, Contracts of Adhesion—Some Thoughts About Freedom of Contracts, 43 Colum. L. Rev. 629 (1943). The high-water mark in judicial doctrine may have been Henningsen v. Bloomfield Motors, 32 N.J. 358 (1960). 2 Distinction between price and non-price terms, as used in the literature, is often unclear. See infra --. 3 In Part II.A., we identify two versions of this conventional wisdom as irrelevance propositions. First, the strong- form version stands for the proposition that bargaining power only affects price and has no effect on non-price terms. Second, in the weak-form version, bargaining power may affect non-price terms, but the parties are no more likely to agree to inefficient non-price terms under unequal, than equal bargaining power. Various statements of the conventional wisdom are found in Richard Epstein, Unconscionability: A Critical Reappraisal, 18 J. L. Eon. 293 Page 3 of 59 Electronic copy available at: http://ssrn.com/abstract=2010083 Choi and Triantis Bargaining Power and Contract Design Version: March 11, 2012 Empirical literature on the relationship between bargaining power and non-price terms, such as warranties, is thin but mixed.4 Recently, in a study of terms in end user licensing agreements (EULAs), Marotta-Wurgler found no evidence to support the hypothesis that market concentration causes terms to be more seller-friendly than in competitive markets.5 The study suggests, therefore, that market power alone should not be sufficient to trigger the scrutiny of a court under the doctrine of unconscionability.6 In contrast, Ben-Shahar and White examined auto-manufacturer supply contracts and found variations in non-price terms, such as warranty and termination provisions, that seemed correlated with bargaining power.7 While reading and search costs may be a confounding factor in consumer standard-form contracts, such as the EULAs in Marotta-Wurgler’s study, Ben-Shahar and White’s sample is pertinent to our analysis because it contains business-to-business contracts where this factor is less likely or unlikely to be an issue. In light of the conventional wisdom in law-and-economics, Ben-Shahar and White were surprised by their observation of variation and inefficiency, remarking that “[g]iven the enormous stakes, we expected that economic power would be used to dictate low prices, not selfish boilerplate.”8 They speculated that the variation and the potential inefficiency was due to (1975); Alan Schwartz, A Re-Examination of Nonsubstantive Unconscionability, 63 Va. L. Rev. 1053, 1071-6 (1977) (“Given… three [weak] assumptions, a firm will produce the same level of product quality regardless of whether the firm is a monopolist or a perfect competitor”); George L. Priest, A Theory of the Consumer Product Warranty, 90 Yale L.J. 1297, 1320-21 (1981); Alan Schwartz and Louis L.